Thursday, July 14, 2011

Trader Myths

Now think of what a trader does. A trader's job is to be smarter than the market. He converts a mess of analysis and intuition into simple bets. He makes moves. If his predictions are better than everyone else's, he wins money; if not, he loses it.

The article is a hagiographic view of traders, like writing that politicians are the best-of-the-best, constantly working on how they can best advance social welfare by seeing win-win exchanges mere mortals cannot. If you are a trader, you might want to send it to your mom or girlfriend.

Traders supposedly described in the article are not like day traders, more like bookies who make money off the vig, and have little insight about 'true value' but usually a lot of franchise value in their brand or network of contacts, which is why they aren't as smart as they would be if they were simply price-taking market wizards. Indeed, most of the first Market Wizards book naively conflated market making and speculating, but when the legend becomes folk wisdom, print the legend, because people obviously like comforting myths.

When traders buy and sell the same stuff right away, it's perfect, they make money without risk. When they have to inventory it, they need it hedged and they have to hope it was priced well, which shows up statistically in the inventory depreciation. Hedging is not insanely complicated for the risk factors you can hedge, and for those you can't you have understood limits (the Serenity Prayer is especially important).

Now for 'equity derivatives people', you have to take a collection of non-standard derivatives, price them, and add some profit to anticipate adverse selection and cover your fixed costs plus any transaction costs (eg, the cost of implementing necessary hedges). Consider the following equity derivative transaction described in the article:

"We want a monthly stream of 12% returns as long as price X stays above 95, a downside no greater than Y, and a coupon of 120% of the principal in the event that A, B, and C all happen on or before the close of trading on April 11th."

If you want a 12% return in this market, that's about 11% more than Libor. An 11% yield necessarily has about an 18% default rate in a risk neutral world assuming a 50% loss-in-event-of-default, higher if you believe in a risk premium. The structure he describes is like asking Match.com:

Equity derivative traders are constrained by simple present values, the expected value discounted by libor, applying probabilities from market prices for options and underlyings. This will be the lower bound to any price quoted to the buyer; they can't create 12% yields without massive downside any more than a pool of subprime loans can create a AAA security without massive subordinate tranches.

16 comments:

r2d2
said...

Let me take your equity derivatives further. That structure sure has a lot of downside for the bank, but you supposedly pass the downside to somebody else via dynamic hedging using just vanilla liquid products, and still have plenty of positive PL left on the trade. Banks were way too quick to recognize that as real profit and pay the trader a percentage of that in cash as bonus. The profit hadn't been earned yet, it existed only on paper, and would have become cash only if a long list of model assumptions had proved to be true over the life of the trade. They didn't (in many cases).

PL recognition is under better control in the real economy. If your run a factory, you can’t say "according to this sophisticated model, it is reasonable to assume we will be able to sell the inventory at a profit of 10 million, so let's declare a profit of 10 million right away and pay the manager 10% as bonus". You have to realize it = sell the inventory (at least the operational profit part) before you are allowed to declare profit and anybody gets rewarded for performance. Banks found a way to bypass that.

The consequence of this (probably unintended) is that certain bank employees stumbled upon an easy way to print profit and get bonuses. You print more long dated stuff and get your bonus at year end. After that model assumptions are not your problem any more. It worked for a couple of years, enough to make some people very rich. Some top guys in the bank who look at the PL and VaR but have no clue where they come from will think that you are the man, and that this is the way of the future (remember the managers in the movie "rogue trader"). Certain variations become very popular, banks print more and more of them, which undermines the very model assumptions they are all relying on - that there is a liquid market in the hedges. With each market move, all banks will have to rebalance their books and will need the same hedge at the same time. The counterparty is some investor who doesn't do delta hedging, maybe never even heard of the concept, so you won't meet him in the market when you need to hedge. It's "portfolio insurance" all over again.

Regulators are quick to find fault with "propiretary trading" but seem to be blissfully unaware that banks get screwed by their own employees while playing by the rules. US banks did it big time, so did AIG financial products (I know some of the guys…). People still do it to this day, but not in the derivatives that blew up last time, those are "toxic". They do new ones until they become toxic, with the same PL recognition trick - all on day one. I don't see how increasing capital requirements will fix this one.

I don’t think there is anything wrong with derivatives. They just ended up in the hands of some bank bureaucrats who don't understand them.

I remember studying the anomalously high BBB-AAA spread, which has a long literature, and noting it would be a good trade back in 1998. I pitched the idea to a guy with the ability to implement such a trade at Deutsche bank, and he noted, quite rightly, that the tails of that trade were too big: when you lost, you lost big, too big. I agreed, and put it behind me.

It seems many banks had that trade on, funding at libor, buying BBB rated ABS, and rationalized using 5-day VARs when they blew up in 2008 (see UBS's mea culpa). So, at some point, that argument worked, and the fat tails that anyone with some grey hair could see, were ignored. Was it inevitable? Perhaps.

In illiquid asset classes traders can add significant value when moving large positions, especially if they interact more directly with the counterparty instead of the all-knowing, always efficient market.

I do hope the next post will describe all the value that has been added by fragmenting our (especially equity) markets into dozens of opaque venues dominated by rebate whore computer algos that turn off the liquidity spigots the second any clouds roll in ;)

...because they were at the mercy of program trading! (which, granted was in turn at the mercy, in some cases, of badly conceived portfolio insurance).

No, I'm well aware that the old system involved a lot of unnecessary tollbooths but what we have now isn't particularly transparent and I think the lack of centralization ultimately hampers price discovery.

I had higher hopes for a computerized market structure other than low transaction costs. In this day and age one market participant shouldn't be able to gain an advantage over everyone else by DIGGING A TUNNEL to the exchange: http://investoholic.net/general/99-wall-streets-speed-war

It has always kind of annoyed me that those kind of guys call themselves traders. They are not. They have an order. They try to put something together at a cost to themselves that will make a big profit by filling the order. It is a very valuable skill, but it is not trading. Trading is buying or selling something and exposing yourself to market risk and an unknown outcome. I'd like to see what those guys could do if they really traded and weren't filling orders. Does anyone but me think their profitability would go down significantly?

@ anonymousFrom what I've seen there are two types of "traders" in banks. Some see no point in taking any position based on a view, and just try to capture whatever they can from the bid offer paid by the client. Of these, some can be quite good at it. Others love the job precisely because it allows them to take risk on the side, and client business is some kind of nuisance they have to put up with. Here too some can be quite good, and tend to end up working for funds. It depends who you work with and in which category your boss falls (very important). As long as you stay within your limits, which can be generous, and don't lose money, you don't get asked too many questions.

I agree and second that, I think he's thinking about "New Market Wizards" which had if memory serves Yass, Hull, the Ritchies, Trout and Lipshutz- who imho were ALL bid/ask jockeys, very talented bid/ask jockeys mind you but simple ticket turn boys nonetheless. The guys who really stood out in those early books were Tudor, Kovner in the original and Eckhardt, McKay and Druckenmiller in the second. The guy that SHOULD have got mention and in my mind is the BEST trader ever is Nick Roditi of Soros' team. Now there was a guy who took real risk, major risk and won much more money more often than how much he lost when he did not.

So if you are a woman you are supposed to send it to your girl-friend or mom?I don't deny that most traders out there are men but there are women too.. it is not a competition but they are often very good traders